Will the Chinese economy grow amidst deleveraging?

Despite seemingly mixed messages, China’s great shift from easing to tightening has begun. It is faced with mounting debts. In such a situation, deleveraging is the most preferred to revive the economy of nation. Deleveraging involves rapidly selling out assets to pay off the pending loans, thereby reducing the debt burden.

How the rating agencies degraded China

In May, Moody’s Investor service downgraded China’s credit rating. However, it took less than a day for the Chinese financial markets to recover from the downgrade. Recently, index giant, Morgan Stanley Capital International (MSCI), announced the partial inclusion of China-traded A-shares in the MSCI Emerging Market Index. In spite of this, China is currently under-represented in the global equity indices relative to its economic influence. The inclusion is predicated on being a long and gradual move.

Moody believes that the rapid rise of Chinese debt has the potential to degrade its future prospects, while MSCI thinks that China’s future is grossly under-valued. One focuses on the cyclical story, the other on the secular potential.

There is a reason for these seemingly mixed messages: like advanced economies, China now has a debt challenge. Yet, the context is different and so are the implications.

Debt difference between China and the rest

In 2015, the total debt of the US (private non-financial debt plus government debt) exceeded 251% of the economy. Except for Germany (166%), the comparable figures in other major European economies are reminiscent of those in the US, including UK (249%), France (278%), and Italy (253%). In Japan, the total debt exceeds a whopping 415% of the GDP. In China, it was 221% but it has grown very rapidly.

The numbers illustrate the stakes, not the story. In advanced economies, total debt has accrued in the last half century, the decades following industrialisation. After rapid acceleration amid industrialisation followed by the move to the post-industrial society, their growth has decelerated, along with excessive debt burden in the post-war era.

The advanced economies’ debt is the result of high living standards that are no longer fueled by catch-up growth or by productivity and innovation. Hence, living standards are sustained with a leverage.

In China, total debt has accrued in the past decade, amid industrialisation. Unlike advanced economies, different regions in China are still coping with different degrees of industrialisation. The urbanisation rate is around 56%, which means that intensive urbanisation will continue for another decade or two. Due to the differences in economic development, Chinese living standards remain significantly lower relative to other advanced economies. In advanced economies, debt is a secular burden; in China, it is a cyclical side-effect. Debt in both the forms, if left unmanaged, has the potential to undermine the future.

Rapid rise of Chinese debt

Why did Chinese debt rise so rapidly? In 2008, it was still 132%. Only a tenth of it was central government debt (17%) and it mostly constituted private debt (115%). In 2015, the government debt was about the same (16%), but private debt had soared (205%).

The dramatic increase can be attributed to two surges. The first is the result of the massive 585 billion USD stimulus package of 2009, which contributed to the new infrastructure in China. In addition, it boosted its global growth prospects. It has also unleashed a huge amount of liquidity for speculation, which is today reflected by the excessive local government debt (included in private non-financial debt data).

Another sharp surge followed in 2016, which saw a huge credit expansion as banks extended a record 1.8 trillion USD of loans. It was driven by a robust mortgage growth, despite government measures to cool housing prices. As a result, credit was growing twice as fast as the economy’s growth rate. However, since late 2016, the cyclical story has been shifting.

The herald of deleveraging

For years, policymakers have advocated tougher measures against leverage, which have been expected to follow the 19th National Congress of the Communist Party in the fall. The big news is that deleveraging has already begun. Concurrently, global pressures have increased with the US Federal Reserve’s rate hikes.

In late 2016, the People’s Bank of China (PBoC) adopted a tighter monetary stance and has increased tightening in the ongoing year. In May, according to Reuters, the total social financing fell to 156 billion USD from 200 billion USD; much more than the analysts expected. As the decline was driven by non-bank financing, broad M2 money supply expanded by less than 10% on a year-to-year basis, the slowest pace in two decades.

For now, policymakers’ deleveraging is on track, as long as it does not downgrade the growth target. In China, it is a medium-term project. In advanced economies, deleveraging is likely to take far longer. However, they will not succeed without structural reforms in the same manner as China is executing them to rebalance the economy towards consumption and innovation.

The author is the founder of Difference Group and has served as research director at the India, China and America Institute (USA) and visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Center (Singapore).